“One Cannot Operate A Capitalist System If The State Can Borrow At A Negative Cost”

The following extract from Charles Gave’s (of GaveKal ) latest letter to clients is a must read for all, especially for the central planning members of the FOMC. The punchline is this statement which is so simple and obvious, it is no wonder virtually noone in control has figured it out yet: “One Cannot Operate A Capitalist System If The State Can Borrow At A Negative Cost.”

Consumption bubbles fuelled by negative real rates always contain the seeds of their own destruction. Debt levels get too high and force household deleveraging; meanwhile the currency falls, which improves competitiveness in the global marketplace. The combined effect is a narrowing of the current account deficit. When the world’s reservecurrency nation experiences such a narrowing, the supply of dollars outside of the US falls, and inevitably catches some countries out.

The best way to look at global dollar supply is to remove China and oil from the US current account balance; this is because of the incredible competitiveness of China, and the scarcity-value of oil producers. Excluding oil and China, the annualized US current account has moved from a deficit of 3% of GDP in 2003 to a recent surplus of 1% of GDP.

This improvement in the current account position has taken place despite the fact that most of the world is growing well below its potential. In effect, the US economy has exercised an immense deflationary pressure on the margins of companies outside of the US, and in so doing has managed to “recover” roughly 4 % of its GDP.

This turnaround underlines just how low the value of the US dollar fell after years of dilutive monetary policy. Moreover, the pressure of a cheap dollar has been compounded by mercantilist China’s de facto peg to the US dollar. No wonder so many current account crises are percolating around the world—countries from Egypt to Italy to India have had to deal simultaneously with a hypercompetitive dollar, an undervalued renminbi and higher oil prices:

While the oil producers and China may still be sitting on a ton of US dollars—which they are recycling into USTs and thus keeping US government borrowing costs at bargain-basement levels—the dollar supply elsewhere in the world has fallen sharply. The countries which have no access to the US currency have to start using their foreign exchange reserves to meet their payments (very often to oil producers and China), thus amplifying the problem. When a country is forced to sell reserves, then it has to follow restrictive monetary and budget policies to depress domestic demand and recreate a current account surplus.

The cost of capital rises sharply for the private sector. India today offers a prime example of a country stuck in this corner.

In the chart below , I am showing the 12-month variations of foreign central bank reserves deposited at Fed—this is excluding China (I would also exclude the oil producers, but could not find a way of estimating their forex reserves). Past periods of rundowns in global forex reserves always have been associated with crises.

When the US current account deficit starts closing, the dwindling supply of dollars eventually leads to a panicked rush for dollars. Non-US companies that binged on dollars when the money was cheap and the dollar was forever going down, now find themselves caught out. Every entity with a negative cash flow in dollars scrambles for dollars — even through selling local assets and converting the proceeds — depressing risk assets everywhere.

The US dollar and USTs outperform everything, including industrial metals (see chart overleaf). And of course equities are not spared (see chart overleaf).

Needless to say, if one has to be invested in equities in these periods, stay in the US stock market (as US companies will not have such troubles) and avoid non-US equities except when they become extraordinarily cheap versus the US market (e.g., a ratio below 1.2x).

I could go on and on with other examples, but let’s just get to the point: one cannot operate a capitalist system if the state can borrow at a negative cost. Years of irresponsibly loose monetary policy in the US has led to cheap funding for the US (and other) governments, but difficult credit conditions for the private sector all around the world. As I underlined in How The World Works, negative real rates leads to misallocation of capital which ends in asset deflation, while simultaneously limiting the capacity for recovery by driving out the private sector.

The Fed has been managed by a bunch of Keynesians who care nothing about the role of the dollar as a reserve currency and who probably believed they were managing the central bank of Belorussia or Zimbabwe!

So what’s an investor to do?

Now at this point, the reader may feel I am about to suggest buying a ranch in Oklahoma, a few guns and some nuggets of gold. This is not my recommendation—at least not yet. In fact, for more than a year now, we have been recommending assets with a positive cash flow in US dollars.
We see no reason to change the portfolio yet. Indeed, because the US bond market has absorbed so much of the world’s “panic liquidity,” a
number of US assets are still reasonably priced (corporate bonds) or even cheap (e.g., platform companies, or good quality residential real estate).

The big question is whether there is scope for more sane central banking, and an improvement in liquidity conditions. In some ways I feel hope:

• Oil prices have come down a lot, and the US dollar is rising (despite the Fed’s frenetic distribution of swaps).

• China is internationalizing the RMB and increasingly widening its capital account, to provide another source of liquidity.

• If non-US assets become cheap enough, then more risk capital will start flowing in that direction (a break-down of the euro would be very useful here in so far as it would instantly create a lot of very cheap assets in Italy, Spain, France, etc.)

In an ideal world, central banks would stop manipulating prices and would return to the Wicksellian rule which worked so well from 1983 to 2002—i.e., they would decide to put short rates gradually back at a level consistent with the growth in the local private sector GDP. I know full well that allowing short rates to go up at this time flies against the current Keynesian orthodoxy at the Fed. A few Fed officials have already acknowledged that with the Fed balance sheet as enormously large as it, future QE action will simply have much less bang for the buck. Unfortunately, with Wednesday’s FOMC announcement on additional funds for Operation Twist, it is clear that any voice of reason in that organisation will be drowned out the by Keynesians on board.

I can only take solace from the fact that political winds also do not seem to be blowing in the Fed’s direction. We may have to wait for November—to see if the voters fire the Fed. Such an outcome would be very bullish for global risk assets.